THE BLOG
05/08/2013 04:54 pm ET Updated Jul 08, 2013

The Incentive for Regulators Not to Regulate

Five years later, nearly every mechanism, law, and incentive that led to the global financial meltdown is still in place. Five years later, we are still at risk of our financial institutions collapsing, our 401Ks plummeting, and our jobs vanishing. Five years later, the U.S. economic system is just as fragile and just as at risk.

We need to change the way business is done on Wall Street, and we can start by changing the way we view incentive. In a lot of ways, incentive is good -- drives the U.S. economy; it governs how consumers buy, how bankers bank, and how regulators at the SEC regulate. But up until now, incentive has created a vicious circle, playing an incalculable role in the financial crisis and laying the groundwork for more crises in the future.

A film screened at the Tribeca Film Festival explores this vicious circle as it played out during the atrocious thefts of Bernie Madoff and his associates. In God We Trust shows how regulators at the SEC become close with industry insiders, provide little regulatory oversight, and then leave the public sector, cycling through the revolving door into the private sector and taking a job at a financial firm where former regulators can earn exponentially more than they did in the public sector. It happens all the time.

The problem? Nassim Taleb, a bestselling author and professor at NYU-POLY, argues that regulators under this system have an incentive to make regulations cumbersome and complicated, forcing the financial industry to hire them to decode the onerous regulatory process. Regulators are also able to curry favor by making rules friendly to a financial institution or the industry writ large, setting themselves up for a posh job on Wall Street.

The Project on Government Oversight (POGO) compiled a list of 400 former SEC employees, between 2001 and 2010 who represented private clients in front of the SEC, advocating on their clients behalf, those they previously regulated, in front of their former colleagues. And these are just those former SEC employees that formally worked with the SEC. Countless more are hired to provide 'expert' counsel to private firms.

The solution? Taleb would create a civil servant pledge for those beginning in public service not to make more than a specified amount if they move to the private sector, to ensure "sincerity in service." A lofty and admirable goal, no doubt, but realistically unfeasible. A tension exists here--we recognize these problems of incentive but are unwilling to squelch a person's desire to make loads of money. Making money is not a bad thing--even for a former civil servant. But earning below your market potential while doing a poor job at the SEC, in order to set up a cushy role in the office a former regulatee, is a bad thing.

So what can we do short of barring dedicated public servants from making enough money to send their children to college and pay for health care? For starters, we can end the buddy-buddy relationship between the SEC and the financial industry. The industry needs to be treated fairly across the board and that means Goldman Sachs can't get a free pass just because they enjoy a close relationship with former SEC employees.

In the private sector, moving between firms can be difficult. Case in point, Conan O'Brien waited months to return to TV because of the non-compete clause in his contract with NBC. Currently no such clause exists for SEC employees. This should be fixed; former regulatory employees should have to wait 5 years before taking up residence on Wall Street.

What's more, former regulatory agency employees should be barred from representing any client before the SEC or dealing with the SEC in any respects on behalf of a private firm. Forever. Much like judges and justices who are expected to recuse themselves from hearing cases with which they have a prior or personal connection, former regulators should not be able to write regulation and then get paid to circumvent it on behalf of a private company. It just doesn't make sense.

Furthermore, as the POGO report outlines, the public should know about this con. Former regulatory employees should be required to submit disclosure statements whenever working for or representing a private firm with which the SEC has dealings, not just for a few years, which is currently the case, but for life.

And finally, though it may sound counterintuitive, we should give the SEC the resources and funds they need to provide the kind of oversight of the financial industry necessary to prevent another financial collapse. Targeted resources can help hire a trained and dedicated workforce, with the human power required for such a mammoth job.

We see it in the judiciary and we see it between private companies--rules and norms that protect the institutions they serve--not from bad people but from harmful incentives. Barring such work and tying the hands of regulators may sound harsh, but it is the only way to remove the incentive of people to craft a system that benefits themselves, to the detriment of others. Unless we change the relationship between public and private, we will have another financial collapse like the one from which we are still clawing our way back.

The private sector isn't bad, nor is the SEC, or at least they don't have to be. Common sense reforms that strike at the heart of deleterious incentives are the only ways to cure the financial regulatory system of its toothless regulations and laughable oversight mechanisms.

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